SocGen has published a fantastic, must read big picture report, which compares the world in the 1980/1985-2000/2005 time period and juxtaposes it to what the author, Veronique Riches-Flores predicts will happen over the next two decades years, the period from 2005/2010 to 2025/2030. Unlike other very narrow and short-sighted projections, this one is based not on trivial and grossly simplified assumptions such as perpetual growth rates, but on a holistic demographic approach to perceiving the world. At its core, SocGen compares the period that just ended, one in which world growth was driven by an expansion in supply, to one that will be shaped by an explosion of demand. And, unfortunately, the transformation from the Supply-driven to the Demand-driven world will not be pretty. Summarizing this outlook: "Over the last three decades strong growth in the working-aged population across Asia and the opening-up of world trade have led to considerable expansion in global production capacities. These factors created a highly competitive and disinflationary environment of plentiful supply, which was characterised by low interest rates, a credit boom and, in the financial markets, exuberant appetite for risky assets. As the demographic cycle progresses, we are seeing the emergence of an aging population, which is less favourable to productive investment. Meanwhile the rise in living standards among the emerging population heralds an unprecedented level of growth in demand. The world supply/demand balance is dramatically changing against a backdrop of resource shortages which are likely to favour shorter cycles, increased government intervention in economic affairs and inflation." In other words, contrary to what you may have read elsewhere, the future is about to get ugly. And topping it all off is a Kondratieff cycle chart: what's not to like. Read on.
Visually comparing the two proposed world paradigms:
The world was characterized by a very defined demographic transformation which served as the underpinning of a production capacity explosion:
A rise in the working age population, which provides labour and growth in demand and savings, has always coincided with economic prosperity. This trend, which economists describe as the “demographic dividend” of the first phase of transition from a primitive or stationary demographic structure, with high birth and death rates, to a developed demographic structure, translates in economic terms into a very strong urge to invest, which is the main source of economic development. The countries of Asia excluding Japan reaped spectacular rewards from this demographic transition: between the mid-1980s and the present their rate of investment has increase by the equivalent of more than 10% of the region’s GDP and industrial potential has considerably increased. The surge in investment that began in Southeast Asia has over the last 15 years focused predominantly on China.
Yet demographics must be taken in conjunction with the other core feature defining the world since 1980: the literal New World Order, predicated by the opening of the world to "free trade."
This transition would not have been so great, nor would it have had the global implications it has had, if it hadn’t been accompanied by the opening-up of world trade due to progress in international negotiations which first brought the GATT agreement and then the WTO, with the aim of optimising resources by making better use of competitive advantages.
In a progressively open world, Asian countries drew increasing benefits from their comparative advantage. The sudden abundance of very low cost labour created the conditions for an unprecedented rise in competition on the world labour market which brought even more investment into the region. What these trends did was to bring about a profound shift in the world’s production and labour balance and a radical change in the economic model that was previously in force. Because, although there had always been cost differences from one country to another, access to a globalised market provided the opportunity of exerting more influence than ever before. The liberalisation of trade gave the Asian demographic transition a dimension comparable to that which brought about the same phenomenon in Europe a century earlier, albeit in Europe’s case the scale was far smaller.
Thus the population boom of recent decades triggered, not a substantial rise in demand, as one might at first expect, but a massive increase in supply as a result of the unprecedented expansion of the global production base. Given that the purchasing power of workers in the emerging Asian countries has, up until recently, been too limited to have any real influence on world demand, average global investment per capita continued to grow faster than real consumption in the region between the mid-1980s and 2007, with the gap peaking at almost 40% over the period.
Naturally, just these two drivers did not nearly come close to explaining the hospitable environment for global growth:
These fundamental characteristics have been reinforced by innumerable other economic, political and cultural revolutions which all aided the development of supply: the end of communism and consequently the expansion of the capitalistic model, privatisations and the widespread decline of state intervention, deregulation in most of the major sectors of economic life, the accelerated development of the financial markets, the revolution of communication technologies. All of these factors contributed to an environment shaped by abundant supply, where increasing competition meant that the least competitive were doomed to fail and all sustained prices rises were eradicated. While the central banks congratulated themselves for having kept inflation under control over the years, we can see that they had a good deal of help from the underlying economy. By restricting access to excess liquidity for the goods markets, the context made it a lot easier for the central banks to control the scourge of inflation. Meanwhile disinflation led to a structural weakening in interest rates which was highly beneficial for the conditions underlying global supply… until it eventually led to the financial excesses that caused the crisis in 2008.
This combination of factors created an environment that was particularly favourable for all asset classes, company assets in the first instance, and then credit, bonds and property assets.
While the expansion of the production platform took place primarily in Asia, it was the West that enjoyed the improvement in return on capital. In a hyper-competitive environment, productivity gains improved in proportion to job weakness and, in a context characterised by a structural decline in capital stock and weaker economic growth, this produced a marked improvement in yield on the latter.
Overall these shifts meant that in the universe of large corporations an increasing part of the added value went towards profits and this, combined with a very strong dividend distribution policy, goes a long way towards explaining the paradox of recent years where structurally weak economies and very strong capital market profitability lived alongside each other for so long.
So that was then. And it lead to what can only be described as log growth in all aset classes: we will not insult readers' intelligence by showing a graph of the S&P from 1980 to 2005.
What is next?
SocGen does not sugarcoat it:
The unprecedented economic and financial crisis of 2008 has abruptly altered the course of history and there is no doubt that its effects will have a sustained influence on future developments. However, the crisis itself represents the expression of the end of the excess created by the previous situation and its consequences should play only a secondary role in comparison to the powerful structural changes that are currently sweeping across the globe, namely changing demographic trends, the explosion of demand in emerging countries and the resurgence of physical constraints to growth.
The shift in the global demographic structure that has characterised the last three decades is now coming to an end. Although the global population is expected to continue to grow significantly in the future, with the nine billion threshold likely to be reached in 2040 according to the UN’s latest projections, a third of this growth will be attributable to the expansion of the elderly population, in the developed countries of course, but also in a good number of emerging countries, and particularly Asia.
The biggest demographic change is without doubt the aging of global, both developing and developed, society. This also explains the special role insolvent entitlement structures which are supposed to ensure retirmenet and pensions for ever more people, have in the eyes of current governments:
By 2030, the portion of working age people in the industrialised countries is expected to have fallen by more than 5%, from more than 67% of the population today, to 62%. By contrast, the over-65s are expected to climb from 16% to 22.5%. In Asia excluding Japan, the over-65s are expected to account for 36% (277 million) of the population increase, after having accounted for less than 10% of the increase observed over the previous 30 years. In the region, the portion of working people in the total population will stop growing when the Chinese population embarks on a similar decline to the one projected for the developed countries starting in 2010.
The below should be the first refutation of any brainless idiotic argument which sees the Dow at 20,000 in the near future (absent hyperinflation of course, in which case the Dow will be at 20 billion but be completely worthless).
The economic implications of population growth resulting from an increase in working aged adults in the first case and an increase in over-65s, in the second, are naturally not comparable. While in the first case, the demographic shift favours structural development, in the second case it weighs on development.
The causes are largely understood in the developed countries where the population has already aged considerably. In this case nevertheless, the negative effects that the aging population has on savings and the urge to invest are likely to be accompanied, or even preceded by at least a proportional decline in growth of structural demand, especially in the current context of widespread household/government over-indebtedness. With revenues at least a third lower than those of the working population, the retired population consumes considerably less than the average adult and is far more vulnerable to debt and asset depreciation than younger households. The combined effects of over-indebtedness, property market decline and widespread fiscal tightening are thus likely to be greater in terms of pressure on demand than the effect of demographic aging on supply.
A longer-term demographic snapshot:
By 2030 two-thirds of the needs of the global population will emanate from the emerging world, the population of which is expected to approach seven billion and the economic weight of which is set to double in comparison to today’s level.
The punchline:
So, while up until now less than one billion people have accounted for three-quarters of global consumption, over the course of the next two decades, the new Chinese, Indian, Indonesian, Latin American and African middle classes will bring an additional two billion consumers with similar needs and aspirations as today’s North American, European and Japanese consumers.
Summarized what does this mean: said simply, an explosion in needs manifesting in a huge demand, and shortage, for all sorts of products, both raw and finished.
The global auto market
In 2010 the global auto fleet stood at approximately one billion vehicles. However, based on the increase in revenues per capita and fairly conservative assumptions relating to the increase in equipment ratios in the main emerging countries, the level should spontaneously double by 2030.
To satisfy these new needs, production is going to have to grow at an average rate of 3.5% per annum over the next 20 years, compared with an average annual growth rate of 2.5% over 2002-2008. Although this may not seem too far-fetched at first, we then have to add the renewal of the existing fleet which, based on an average vehicle lifespan that we estimate to be between 10 and 12 years, will have to be completely replaced over the next two decades. Thus, one billion expansion + 1.6 to two billion replacement, which means that, in comparison to the current level, production would actually have to triple rather than double in order to meet future demand, corresponding to an average annual growth rate of not 3.5% but potentially 4.4% (assuming a 10-year average lifespan of a vehicle) to 5.6% (10 year average lifespan) by 2030.
Metals and other inputs
Given that metal accounts for half of the weight of each new vehicle (54% exactly at present), the tripling of auto production between now and 2030 implies a threefold increase in demand for metals, steel alloys, light metals such as aluminium, and textiles, which are also used extensively in vehicle production.
Meanwhile in another field, namely construction, rapid urbanisation and the subsequent increase in tall buildings is also contributing to very strong growth in demand for steel. According to ENRC (Eurasian Natural Resources Corporation), buildings of over 16 floors, where steel intensity is twice as high as in buildings of less than six floors, are expected to account for more than half of all new Chinese constructions between now and 2020.
These few examples are not just the exceptions. At this stage many sectors are projected to encounter increased demand of similar proportions, as the change in lifestyles that accompanies the rise in living standards in the emerging countries affects demand for a considerable range of goods.
Beyond growth in demand for finished products, the most spectacular effect likely to be brought about by the stronger development of the emerging economies will be the enormous rise in demand for raw materials.
The full report (below) indicates the same squeeze in agircultural products and in energy. Yet the take home message is clear: resource shortages are coming back with a vengeance as physical limits on growth once again appear.
Having disappeared from the economic landscape over the last century, resource shortages are back. This will create a particularly unstable environment in the long term, some of the characteristics of which we can already anticipate:
Structural increase in the cost of raw materials. A structural increase in raw materials prices is in fact an inevitable consequence of chronic resource insufficiencies, whether we’re talking about industrial, energy or agricultural resources. Rather than asking which direction real raw materials prices are going, we must now ask how long it will take to erase the long period of price decline seen between 1980s and the 2000s.
Rise in cycle frequency and magnitude. Given that any sustained period of expansion would be likely to run into an ever increasing number of physical constraints as time goes by, cycle durations are likely to become significantly shorter. However, greater cyclicality doesn’t mean that the cycles will be smoother. On the contrary, in view of the factors underlying the increase in demand, the upward phases of the short cycles are likely to be particularly pronounced, triggering recurrent price swings which could act as an automatic stabiliser. Movements in the price of raw materials and their resistance and support points look likely to play a key role in the cyclical shifts of the period.
Rise in cost of capital and slowdown in productivity gains. For economic intermediaries and the investment community, a series of short cycles spells relative instability and reduced visibility. These characteristics are generally bad news for investment as risk-taking would need to be carried out against a backdrop of potential resource shortages. This observation raises questions over the future development of commodity supply despite the context of increasing demand, given that savings sources are declining due to population aging in wealthy countries and this is likely to lead to a shortage of capital supply and a proportional increase in cost of capital. None of this bodes well for company performance. The slowdown in productivity gains that has been observed in the developed countries for almost a decade now thus looks set to continue and to spread to the newly industrialised countries.
State intervention, regionalisation of trade. The underlying scarcity of resources could pave the way towards a resurgence in regulation, as already observed with the restrictions on the trade of raw materials recently imposed by a number of countries. A rise in tensions on the commodities market and a diminishing supply of capital will considerably increase the temptation for governments to become increasingly involved in the management of resources. While strong inter-dependence reduces the risk of a return to widespread protectionism, a significant shift towards the regionalisation of trade, as opposed to the globalisation seen over the last 20 years, seems highly likely. Given the level of interdependence and tension, developments in global governance will be vital, meaning that a stronger regulatory framework will be adopted in an increasing number of economic and financial domains.
And the two most important take home observations:
Return of inflation
The stage is set for the return of inflation. It is merely a question of time before the global inflationary movement gets underway. The realisation that the emerging countries will account for the bulk of the growth in demand does very little to change this conclusion in a world characterised by a high level of inter-dependence and one that is increasingly being driven by the rising influence of these new players. The fall in competition that has already been triggered by the asymmetric demand shock represents the most efficient catalyst for the proliferation of the global price rises that have already been evidenced by the rapid widespread increase in the international trade prices of manufactured goods.
Widespread increase in interest rates
The growing structural imbalance between supply and demand looks set to trigger a very pronounced rise in interest rates as time goes by. There is also a significant risk that this movement will be accentuated by the structural decline in savings capacities on a global level.
And nor for what everyone has been waiting for: what does this all mean for equity markets. Well, it's not all that bad...
The rising power of the emerging economies comes at a high collective cost and raises many questions. To say that this picture does not evoke a scenario of harmonious growth would be an understatement. At the same time, neither does it necessarily evoke a depressive scenario.
Firstly, because as a result of these shifts many billions of people will gain access to an unprecedented level of development and revenues. Young countries with substantial natural resources will find themselves with a significant source of growth in a world of scant resources. Alongside the progress already made by Asia, this new environment will represent a powerful development platform for Africa, forming a trend that is already clearly under way.
Secondly, because long-term economic history shows that a certain level of constraint is needed to stimulate the innovation and transformation that has ultimately allowed mankind to progress. While it is clear that the innovation process is currently lagging behind the development of demand, it is the distortions created by this imbalance that should allow crucial progress to get the upper hand.
Finally, because the changes under way in the emerging world offer the developed world, with its aging and over-indebted population, the only true chance it has of avoiding the projected structural decline that it faces without this external impulsion. At the end of a 30-year process that began at the end of the 1970s with the realisation that, only by distributing wealth through the liberalisation of world trade could the global economy thrive in the long term, the circle is now complete and this is obviously welcome. The years of hyper-competition and flagging industrial employment are drawing to a close. While the decline in productivity gains may not bode well for corporate profitability, it nevertheless marks a radical shift in the environment for the employment markets of the developed countries which, combined with the growth opportunities offered by the emerging markets, provides them with a precious if not their sole support for future growth. What is more, the inflation that will accompany this global economic transition represents the only chance these countries have of reducing their enormous debt burdens in the long term.
The financial outlook for the coming years looks set to encounter all sorts of hurdles and sources of volatility, yet it is not irretrievably headed towards depression.
Alas, the sugarcoating quickly ends when one thinks realistically about things:
It is fair to say that shorter economic cycles, rising raw materials prices, the return of inflation and soaring interest rates undermine the medium-term outlook for the equity markets. Such conditions will no doubt cause continued uncertainty which will probably prevent the developed markets from finding their way for still several more years to come.
And the conclusion: the depression that the developed world lived through in the aftermath of Lehman is slowly shifting to the very same dynamo to carried the world across the abyss and has so far continued to push the global econmoy forward tirelessly.
Paradoxically it is the pressure that this new growth regime puts on the long-term performance of the emerging market capital markets that represents the biggest constraint to the development of the capital markets and their relative performance. The emerging markets have barely had time to absorb the changes that are currently taking place and, at this stage of their development, they would be far more vulnerable to problems created by high inflation.
However, if this were the case, then the characteristics of the Kondratien winter that should emerge in the developed world in the aftermath of the financial crisis could give way to a new Kondratief cycle dictated by the developments of the emerging world.
And yes, what look at the future would be complete without the good old Kondratieff cycle chart which sadly predict that we are now entering the last season of it all.
Indeed, winter will be marked by "concern, fear, panic and despair"; when there is virtually no credit following global credit crunch, when rates and vol fall due to a credit crisis, and when the only assets generating returns are gold, cash and bonds. This is the deflationary endgame, and the world's central banks know it. Throughout history this terminal deflationary threat is what always forces money printing authorities to make their last stand against the end of the cycle, knowing full well the status quo would implode in a singularity of risk off'ness, unless something is done. And that one something is always, without fail, the rampant printing of money to stave off deflation. Always. Without exception. Just open up a history book. And no. This time is never different.
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